Big banks like Bank of America are well-diversified in terms of products, income sources, and geography. But is that always a good thing? While you might think that expanding across regions is a surefire way to improve value, when it comes to bank stocks that's not necessarily the case.
The benefits of geographic diversification
Diversifying away from a particular region could help reduce risk for banks as a business -- and for consumers. A 2006 Federal Reserve Bank study noted that, historically speaking, larger commercial banks are better able to weather economic storms due to their geographic diversification. In other words, a downturn in one area doesn't destroy a larger bank because it's be buoyed by better performance in other regions .
Interestingly, the study also found the converse to be true as well: generally speaking (and the financial crisis notwithstanding), a more diversified banking sector helps local economies weather economic storms. Large banks can continue to provide credit to local businesses because they aren't as strapped for cash as local banks. Diversification also helps growth. Philip E. Strathan, also of the Fed, noted that local economic growth sped up during a lengthy period of bank deregulation, probably due to increased lending to new businesses. Strathan found that this didn't come at the cost of more risk: economic volatility also dropped over this period .
Thus, geographic expansion by banks seems to improve local economic performance in general, and it seems to help banks to better weather local downturns when they do occur.
What about the value of my bank stock?
There appear to be obvious benefits to geographic diversification. But as a shareholder, are you capturing that value? A 2011 paper for the National Bureau of Economic Research notes that while there may be value generated by geographic diversification, there are also certain risks.
The authors found that the value of banks (measured using Tobin's q, which compares market value to book value) dropped as the complexity of their operations increased. Why would that be? They hypothesize that as operations expand, shareholders have a harder time monitoring the activities of bank executives, making it easier for them to benefit privately instead of passing on benefits to shareholders . This ultimately erodes the value of the company.
That would suggest that larger, more complex banks like Bank of America and Citigroup would be given lower valuation multiples than smaller, easier-to-understand counterparts like Bank of Hawaii.
Which bank should you buy, then?
None of this means that you should avoid larger or more geographically dispersed banks like Bank of America. It simply means that there might be costs associated with larger banks that you should be aware of as an investor.
It also means that banks like B of A may not garner the same valuation multiples of smaller banks. The gap between Bank of America's current price-to-tangible book value of 1.2 and Bank of Hawaii's 2.6 is likely largely due to the fact that B of A is still recovering from the financial crisis and has been reporting lackluster returns for shareholders. However, some gap could persist if investors perceive the big bank as too complex and difficult to pick apart.
If you're interested in regional banks, which at least one Forbes contributor believes might do well in the coming years , perhaps start by perusing those banks that match your strategic preferences.
I've previously advised that investors also pay attention to revenue sources since higher proportions of noninterest income at a bank has the potential to lead to higher volatility and risk. Bank of Hawaii, for instance, generates the bulk of its revenue, or about 67%, from interest income, while the percentage is just 48% at Bank of America. Other banks, like Goldman Sachs (NYSE:GS) generate most of their revenue from non-interest income, a feature that gives these banks very different risk characteristics versus other national and global competitors.
Either way, it makes sense to pay attention to geographic diversification and the other factors that affect a bank's business model and potential risks. If one of your holdings is looking to, for example, acquire another bank in a different market, you might want to consider whether you think the merger will generate value over the long haul. Is the resulting company likely to be clunky and complex? Will it know how to operate in dispersed regions? Diversification can produce benefits, but it's worth watching out for the potential costs.
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Anna Wroblewska has no position in any of the stocks mentioned. The Motley Fool recommends Bank of America and Goldman Sachs. The Motley Fool owns shares of Bank of America, Bank of Hawaii, and Citigroup. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.